Chapter 10 Entrepreneurship by Zubair A Khan.

Chapter 10 - Pricing and Credit Strategies

“The price is what you pay; the value is what you receive.” Anonymous

Learning Objectives Students will be able to: 1. Describe Describe effective effective pricing pricing techniques techniques for both both new and existing existing products products and services. services. 2. Discuss Discuss the the links links among among prici pricing, ng, image, image, and and competiti competition. on. 3. Explain Explain the pricing pricing techniqu techniques es used used by by retail retailers. ers. 4. Explain Explain the pricing pricing technique techniquess used by manufac manufacturer turers. s. 5. Explain Explain the pricing pricing technique techniquess used by servic servicee firms. firms. 6. Descri Describe be the impa impact ct of credi creditt on prici pricing. ng. Instructor’s Outline I. Introduction A. Overview 1. Pricing is almost always one of the entrepreneur’s greatest challenges. a) If the price of your product or services is perceived to be too high, sales may not reach an adequate level for the business to become profitable. b) In the opposite extreme, pricing products or services too low may convey an image of inferior quality. c) Even if sales do occur, the lower price may not result in an adequate profit margin. 2. A serious “side effect” of pricing too low is the reaction of customers when you attempt to adjust prices upward. a) Your customers will remember the initial low price and they may even feel their loyalty is being taken advantage of. 3. In reality, the pricing process is somewhere between an exact science based on logical factors and an intuitive insight based gut feeling. 4. Determining the most appropriate price for a product or service requires an entrepreneur to consider how each of the following factors will interact with one another. a) Product or service costs b) Market factors: supply and demand c) Sales volume d) Competitors' prices e) The company's competitive advantage f) Economic conditions g) Business location h) Seasonal fluctuations i) Psychological factors j) Credit terms and purchase discounts; Customers' price sensitivity; Desired image 5. In academic terms, price is the monetary value of a good or service. 197

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Section IV Small Business Marketing Strategies

a) Price is a measure of what a customer is required to give up to obtain a good

or service. b) For an individual, price is a reflection of value. We, as individuals, pay no more than what we believe the good or service to be worth. c) The process of setting the price for any good or service must involve an analysis of how the market views the value of that product or service. B. Entrepreneurs must develop a keen sensitivity to the psychological and economic

thinking of their customers. 1. Without being “in tune” to the customer’s psychological and economic motivators and the resultant most likely buying behavior, it is possible to price the good or service incorrectly. a) This needed customer orientation is an important non-quantitative factor in a successful pricing process. b) What the process achieves is seldom an “ideal” price, but a price range. 2. Price ceiling, which is the most the target group would be willing to pay, and the price floor. a) The price floor is established by the firm’s total cost to produce the product or provide the service. depen ds on the desired image they want wa nt 3. The final price that business owners set depends to create for their products or services: discount (bargain), middle-of-the-road (value), or prestige (upscale). 4. Business owners must walk a fine line when pricing their products and services, setting their prices high enough to cover costs and earn a reasonable profit but low enough to attract customers and generate an adequate sales volume. 5. Furthermore, the right price today may be completely inappropriate tomorrow because of changing market and competitive conditions. 6. Businesses faced with rapidly rising raw materials costs should consider: a) Communicate with customers. Let your customers know what's happen ing. b) Focus on improving efficiency everywhere in the company. c) Consider absorbing cost increases to save accounts with long-term importance to the company. Saving a large account might be more important than keeping pace with rising costs. d) Emphasize the value your company provides to customers. Unless a company reminds them, customers can forget the benefits and value its products offer. e) Anticipate rising materials costs and try to lock in prices early. It pays to keep tabs on raw materials prices and to be able to predict cycles of inflation.

Chapter 10 - Pricing P ricing and Credit Strategies

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IN THE FOOTSTEPS OF THE ENTREPRENEUR What if the Customer Sets the Price? Although this may sound ridiculous, would you believe that for the past 15 years Michael Vasos, a successful London, England restaurant owner has operated one of his businesses exactly that way. Around the corner is a restaurant restaurant where, upon completion of your meal, you (the customer), pays the owner what you felt the meal was worth. Vasos says that he “makes more money from this restaurant than any of my other establishments.” The restaurant is booked every night and revenues exceed $1 million. What does this tell us about ourselves? Do we not know the value of a product or are we willing to reward an entrepreneur who we feel trust our judgments and basic honesty? Answer: Student’s answers will vary. II.

Pricing Strategies and Tactics A. New Products: Penetration, Skimming, or Sliding 1. Most entrepreneurs approach setting the price of a new product with a great deal of apprehension because they have no precedent. 2. When pricing any new product, the owner should try to satisfy three objectives: a) Get the product accepted. No matter how unusual a product p roduct is, its price must be acceptable to the firm's potential customers. b) Maintain market share as competition grows. If a new product is successful, competitors will enter the market, and the small company must work to expand or at least maintain its market share. c) Earn a profit. Obviously, a small firm must establish a price for the n ew product that is higher than its cost. Managers should not introduce a new product at a price below cost because it is much easier to lower the price than to increase it once the product is on the market. 3. Entrepreneurs have three basic strategies to choose from in establishing a new product's price: penetration, skimming, and sliding down the demand curve. 4. Penetration a) If a small business introduces a product into a highly competitive market in which a large number of similar products are competing for acceptance, the product must penetrate the market to be b e successful. b) To gain quick acceptance and extensive distribution in the mass market, a company introduces the product at a low price--just above total unit cost to develop a wedge in the market and quickly achieve a high volume of sales. c) The resulting low profit margins may discourage other competitors from entering the market with similar products. d) A penetration pricing strategy is used to introduce relatively low-priced goods into a market where no elite segment and little opportunity for differentiation exist. e) The introduction is usually accompanied by heavy heav y advertising and promotional techniques, special sales, and discounts. f) The objective of the penetration strategy is to achieve quick access to the market in order to realize high sales volume as soon as possible.

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5. Skimming a) A skimming pricing strategy often is used when a company introduces a new

product into a market with little or no competition. b) Sometimes a company uses this tactic when introducing a product into a competitive market that contains an elite group that is able to pay a premium price. c) The firm uses a higher-than-normal price in an effort to quickly recover the initial developmental and promotional costs of the product. d) Product development or start-up costs usually are substantial owing to intensive promotional expenses and high initial costs. e) The idea is to set a price well above the total unit cost and to promote the product heavily to appeal to the segment of the market that is not sensitive to price. f) This pricing tactic often reinforces the unique, prestigious p restigious image of a store and projects a quality picture of the product. 6. Sliding down the demand curve a) One variation of the skimming pricing strategy is called sliding down the demand curve. (1) The small company introduces a product at a high price. e nable the firm to lower its costs (2) Then, technological advancements enable quickly and to reduce the product's price sooner than its competition can. b) By beating other businesses in a price decline, the small company discourages competitors and, over time, becomes a high-volume producer. c) Computers are a prime example. d) Sliding is a short-term pricing strategy that assumes that competition will eventually emerge. B. Established Goods and Services 1. Odd pricing a) Although studies of consumer reactions to prices are mixed and generally

inconclusive, many small business managers use the technique known as odd pricing. b) They set prices that end in odd numbers (frequently 5,7,9) because they believe that an item selling for $12.95 appears to be much cheaper than an item selling for $13.00. 2. Price lining a) Price lining is a technique that greatly simplifies the pricing function. b) The manager stocks merchandise in several different price ranges or price lines. Each category of merchandise contains items that are similar in appearance, quality, cost, performance, or other features. c) Most lined products appear in sets of three--good, better, and best--at prices designed to satisfy different market segment needs and incomes. 3. Leader pricing a) Leader pricing is a technique in which the small retailer marks down the customary price (i.e., the price consumers are accustomed to paying) of a popular item in an attempt to attract more customers.


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b) The company earns a much smaller profit on each unit because the markup is

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lower, but purchases of other merchandise by customers seeking the leader item often boost sales and profits. Geographic pricing a) Small businesses whose pricing decisions are greatly affected by the co sts of shipping merchandise to customers across a wide range of geographic regions frequently employ one of the geographic pricing techniques. b) Zone pricing--a small company sells its merchandise at different prices to customers located in different territories. (1) The small business must be able to show a legitimate basis (e.g., difference in selling or transportation costs) for the price discrimination or risk violating Section 2 of the Clayton Act. c) Uniform-delivered pricing--a technique in which the firm charges all of its customers the same price regardless of their location, even though the cost of selling or transporting merchandise varies. d) The firm calculates the proper freight charges for each e ach region and combines them into a uniform fee. e) F.O.B. factory--the small company sells its merchandise to customers on the condition that they pay all shipping costs. Opportunistic pricing a) When products or services are in short supply, customers are willing to pay more for products they need. b) Some businesses use such circumstances to maximize short-term profits by engaging in price gouging. c) Opportunistic pricing may backfire, however, because customers know that a company that charges unreasonably high prices is exploiting them. Discounts a) Many small businesses use discounts, or markdowns, reductions from normal list prices, to move stale, outdated, damaged, or slow-moving merchandise. b) A seasonal discount is a price reduction designed to encourage shoppers to purchase merchandise before an upcoming season. c) Some firms grant purchase discounts to special groups of customers. Multiple pricing a) Multiple pricing is a promotional technique that offers customers discounts if they purchase in quantity. Bundling a) Bundling is the grouping together of several products or services, or both, into a package that offers customers extra value va lue at a special price. Suggested retail prices a) Many manufacturers print suggested retail prices on their products or include them on invoices or in wholesale catalogs. b) Small business owners frequently follow these suggested retail prices because doing so eliminates the need to make a pricing decision. (1) Following prices established by a distant manufacturer may create problems for the small firm.

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(2) Another danger of accepting the manufacturer's suggested price is that it

does not take into consideration the small firm's cost structure or competitive situation. IN THE STEPS OF THE ENTREPRENEUR Nine Steps to Maximizing Profits Through Optimal Pricing 1. Compare Compare your your prices prices with those of compet competitor itors. s. 2. Check with associati associations ons who who conduct conduct pricing pricing studies studies.. 3. Attempt Attempt to develop a formula formula for settin setting g prices that that is specifical specifically ly relevant relevant to your business business.. 4. For service service compani companies, es, one method method is to calculate calculate backward. backward. 5. Set a price price that includes includes the the time you you provide provide that cannot cannot normally normally be charged charged to the the client. client. 6. Attempt Attempt to find find what is termed termed “a magic magic number”. number”. Although Although your your pricing pricing formulas formulas produce produce a retail price of $30.95, you may discover that the volume you can sell is priced at $29.95 more than compensates for the one-dollar reduction. Your goal is to maximize total net revenue and the $29.95 price may significantly increase sales volume. 7. Price shrinki shrinking ng may allow allow a new firm to set a higher-th higher-than-norm an-normal al price initial initially ly and then lower the price later. later. It is easier to to explain a price reduction than a price increase. 8. Charge what what the market market will will bear. Custom Customer er willingnes willingnesss to buy sets sets the price price ceiling ceiling for your product or service. Attempt to continue to add value value in the eyes of your customers. 9. Charge what what you’re you’re worth. worth. If the the service service you provide provide or the product product you you sell is is unique or a product of your special skills, don’t be embarrassed embarrassed to charge what you’re worth. worth.

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Two Potent Pricing Forces: Image and Competition A. Price Conveys Image 1. A company's pricing policies offer potential customers important information about its overall image. a) High prices frequently convey the idea of quality, prestige, and uniqueness. 2. Accordingly, when developing a marketing approach to pricing, business owners must establish prices that are compatible with what their customers expect and are willing to pay. a) Too often, small business owners under price their go ods and services, believing that low prices are the only on ly way they can achieve a competitive advantage. 3. Business owners must recognize that the prices they set for their company's goods and services send clear signals to customers about quality and value.


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B. Competition and Prices 1. An important part of setting appropriate prices is tracking competitors' prices

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regularly; however, what the competition is charging is just one variable in the pricing mix. Businesses that offer customers extra quality, value, service, or convenience can charge higher prices as long as customers recognize the "extras" they are getting. Two factors are vital to studying the effects of competition on the small firm's pricing policies. a) The location of the competitors. b) The nature of the competing goods. In most cases, unless a company can ca n differentiate the quality and the quantity of extras it provides, it must match the prices charged by nearby competitors for identical items. a) Although the prices that distant competitors charge are not nearly as critical to the small business as are those of local competitors, co mpetitors, it can be helpful to know them and to use them as reference points. b) Before matching any competitor's price change, however, the small business owner should consider the rival's motives. The nature of competitors' goods also influences the small firm's pricing policies. a) The manager must recognize which products are substitutes for those he sells and then strive to keep prices in line with them. In general, the small business manager should avoid head-to-head price competition with other firms that can more easily achieve lower prices through lower cost structures. One of the deadliest games a small business can get into with competitors is a price war. a) Price wars usually begin when one competitor believes that they can achieve a higher volume through lower price, or they believe they can exert enough pressure on competitor’s profits to drive them out of business. b) Entrepreneurs overestimate the power of price cuts to increase sales sufficiently to improve net profitability. In a price war, a company may cut its prices so severely that it is impossible to achieve the volume necessary to offset the lower profit margins. a) "If you have a 25 percent gross [profit] margin, and you cut your price 10 10 percent, you have to roughly rough ly triple your sales volume just to break even." The underlying forces that dictate how a business prices its goods or services vary greatly among industries.

Pricing Techniques for Retailers

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GAINING THE COMPETETIVE EDGE Don’t Forget to Raise Prices It may sound silly to remind business owners that they need to raise prices when they experience cost increases. Norm Brodsky’s advice is to increase prices in small increments that reflect increased costs of doing business. When a business owner fails to increase their prices in this fashion they eventually eventually discover that big increases increases are a shock to customers. Even when the new prices are in line with those of competitors the entrepreneur may loose customers. Even in a period of low inflation costs do rise, (maybe 2.7 percent per year). If the costs are not reflected in higher prices, the compound effect of even 2% over 5 years can take a significant bit out of overall profits.

A. Markup 1. The basic premise of a successful business operation is selling a good or service

for more than it costs to produce it. 2. The difference between the cost of a product or service and its selling price is called markup (or markon). 3. Markup can be expressed ex pressed in dollars or as a percentage of either cost or selling price: a) Dollar markup = Retail price - Cost of the merchandise b) Percentage (of retail price) markup = Dollar markup Retail price 4. Percentage (of cost) markup = Dollar markup Cost of unit 5. The cost of merchandise used in computing markup includes not only the wholesale price of the merchandise but b ut also any incidental costs (e.g., selling or transportation charges) that the retailer incurs and a profit minus any discounts (quantity, cash) that the wholesaler offers. 6. Once business owners have a financial plan in place, including sales estimates and anticipated expenses, they can compute the firm's initial markup. 7. The initial markup is the average markup required on all merchandise to cover the cost of the items, all incidental expenses, and a nd a reasonable profit. 8. Initial dollar markup = Operating expenses + Reductions + Profits Net Sales + Reductions 9. Operating expenses are the cost of doing business, such as rent, utilities, and depreciation; reductions include employee and customer discounts, markdowns, special sales, and the cost of stockouts. 10. Some businesses use a standard markup on all of their merchandise. a) Usually used in retail stores carrying related products, it applies a standard percentage markup to all merchandise. b) Most stores find it much more practical to use a flexible markup, which assigns various markup percentages to different types of products. 11. Once owners determine the desired markup percentage, they can compute the appropriate retail price.


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12. Finally, retailers must verify that the computed retail price is consistent with their

planned initial markup percentage. B. Follow-the-Leader Pricing 1. Some small companies simply follow the prices that their competitors establish. 2. Managers wisely monitor their competitors' pricing policies and individual prices

by reviewing their advertisements or by hiring part-time or full-time comparison shoppers. C. Below-Market Pricing 1. By setting prices below those of their competitors, these firms hope to attract a

sufficient level of volume to offset the lower profit margins. 2. Many retailers using a below-market pricing strategy eliminate most of the extra services that their above-market-pricing competitors offer. V.

Pricing Techniques for Manufacturers A. Cost-plus Pricing 1. The most commonly used pricing technique for manufacturers is cost-plus pricing. 2. Using this method, manufacturers establish a price composed of direct materials, direct labor, factory overhead, selling and administrative costs, plus the desired profit margin. 3. The main advantage of the cost-plus pricing method is its simplicity. 4. Given the proper cost accounting data. computing a product's final selling price is relatively easy. 5. Also, because it adds a profit onto the top of the firm's costs, the manufacturer is guaranteed the desired profit margin. 6. It does not encourage the manufacturer to use its resources efficiently. 7. Finally, because manufacturers' cost structures vary so greatly, cost-plus pricing fails to consider the competition sufficiently. B. Direct Costing and Price Formulation 1. One requisite for a successful pricing policy in manufacturing is a reliable cost

accounting system that can generate timely reports to determine the costs of processing raw materials into finished goods. 2. The traditional method of product costing is called absorption costing because all manufacturing and overhead costs c osts are absorbed into the finished product's total cost. a) Absorption costing includes direct materials and direct labor, plus a portion of fixed and variable factory overhead costs, co sts, in each unit manufactured. 3. A more useful technique for managerial decision-making is variable (or direct) costing, in which the cost of the products manufactured includes only those costs that vary directly with the quantity produced. a) Variable costing encompasses direct materials, direct labor, and factory overhead costs that vary with the level of the firm's output of finished goods.

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4. A manufacturer's goal in establishing prices is to discover the cost combination of

selling price and sales volume that exceeds the variable costs of producing a product and contributes enough to cover fixed costs and earn a profit. a) Full-absorption costing is that it clouds the true relationships among price, volume, and costs by including fixed expenses in unit cost. b) Direct-costing basis yields a constant unit cost of the product no matter what the volume of production is. 5. The starting point for establishing product prices is the direct-cost income statement. a) As Table 10.1 indicates, the direct-cost statement yields the same net profit as does the full-absorption income statement. b) The only difference between the two statements is the format. C. Computing a Breakeven Selling Price 1. A manufacturer's contribution percentage tells what portion of total revenues

remains after covering variable costs to contribute toward meeting fixed expenses and earning a profit. 2. This manufacturer's contribution percentage is 36.5 percent, which means that variable costs absorb 63.5 percent of total revenues. a) In other words, variable costs represent 63.5 percent (1.00 - 0.365 = 0.635) of the product's selling price. b) Suppose that this manufacturer's variable costs include the following: Material $2.08/unit Direct labor $4.12/unit Variable Variabl e factory overhead overhe ad $0.78/unit $0.78 /unit Total variable cost $6.98/unit 3. The minimum price at which the manufacturer would sell the item is $6.98. Any price below that would not cover variable costs. 4. To compute the breakeven selling price for this product, find the selling price using the following equation: (Selling x Quantity) + (Variable cost x Quantity) + Total (price (pri ce produce prod uced) d) (per (pe r unit uni t produc pro duced) ed) fixed fixe d cost cos t Profit = Quantity produced which becomes: Profi ofit + (Variable Cost x Qua Quantity) per unit produce prod uced) d) Profit = Quantity produced

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5. Because the manufacturer's capacity in the short run is fixed, pricing decisions

should be aimed at using its resources most efficiently. 6. The fixed cost of operating the plant cannot be avoided, and the variable costs can be eliminated only if the firm ceases to offer the product.


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7. Therefore, the selling price must be at least equal to the variable costs (per unit) of o f

making the product. Any price above that amount contributes to covering fixed costs and providing a reasonable profit. 8. Over the long run, the selling price must cover total product costs--both fixed and variable--and generate a reasonable profit. VI.

Pricing Techniques for Service Firms A. The Basis for Pricing 1. Service businesses must establish their prices on the basis of the materials used to provide the service, the labor employed, an allowance for overhead, and a profit. 2. A service firm must have a reliable, accurate accu rate accounting system to keep a tally of the total costs of providing the service. a) Most service firms base their prices on an hourly rate, usually the actual number of hours required to perform the service. b) Some companies, however, base their fees on a standard number of hours, determined by the average number of hours needed to perform the service. c) For most firms, labor and materials constitute the largest portion of the cost of the service. d) To establish a reasonable, profitable price for service, the small business owner must know the cost of materials, direct labor, and overhead for each unit of service. e) Using these basic cost data and a desired profit margin, the owner of the small service firm can determine the appropriate price for the service. 3. Consider a simple example for pricing a common service--television repair. a) Ned's TV Repair Shop uses the direct-costing method to prepare an income statement for exercising managerial control. b) See Table 10.2. 4. Smart service shop owners compute the cost per production hour at regular intervals throughout the year because they know kno w that rising costs can eat into their profit margins very quickly. 5. Rapidly rising labor costs and materials prices dictate that the service firm's price per hour be computed even more frequently.

VII. The Impact of Credit on Pricing A. Introduction 1. Individuals on the eastern seaboard have more credit cards and the highest credit

limits. a) In contras contrast, t, the most conserv conservati ative ve credit credit card card users users were were locate located d in the Midwest. b) Interest payments on credit card balances have now become a significant part of our monthly budget. 2. Today’s entrepreneur needs to take all of the steps necessary to be compliant with the customer’s desire to buy now and pay later. 3. Companies must pay to use the system, typically 1 to 6 percent of the company’s total credit card charges, which they must factor into the prices of their products or services.

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a) They also pay a transaction fee of 5 to 50 cents per charge and must purchase

or lease equipment to process transactions. b) Given customer expectations, small businesses find it difficult to refuse major cards, even when the big card companies raise the fees that merchants must pay. (1) Fees operate on a multi-step process. 4. Before it can accept credit cards, a business must obtain merchant status from either a bank or an independent sales organization (ISO). a) The accompanying Gaining the Competitive Edge feature describes how a small company can obtain merchant status. 5. More small businesses also are equipping their stores to handle debit-card transactions, which act as electronic checks, automatically deducting the purchase amount from a customer’s checking account. a) The equipment is easy to install and to set up, and the cost to the company is negligible. b) The payoff can be big, in the form of increased sales. 6. Credit card sales have many associated fees. a) Not all merchant account providers charge all of these fees, but expect to see some of these: (1) application fee (usually waived) (2) equipment fee (3) licensing fee (4) transaction fee (5) holdbacks and chargebacks.


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GAINING THE COMPETITIVE EDGE How to Obtain Merchant Status Acquiring merchant status enables a small business to accept credit-card payments for goods and services. Offering customers the convenience of paying with credit cards enhances a company’s reputation and translates translates directly into higher sales. sales. Qualifying for merchant status is not easy for many small companies, however, because bec ause banks view it in the same manner as making a loan to a business. Although small storefront storefront businesses with short short operating histories many have difficulty qualifying for merchant statues, home-based businesses and mail-order companies or entrepreneurs doing business over the World Wide Web typically have the greatest difficulty convincing banks to set them u p with credit card accounts. What can business owners do to increase their chances of gaining merchant status so that they can accept customers without driving their costs sky-high? Try these tips: Recognize that business start-ups and companies that have been in business less than three years face the greatest obstacles in gaining merchant status. Apply with your own bank first. Know what information the bank or ISO is looking for and be prepared to provide it. Make sure you understand the costs involved. Shop around. Have a knowledgeable attorney to look over your contract before you sign it. •

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Accepting credit cards is not important for every business, but for those whose customers expect that convenience, acquiring merchant status can spell the difference between making a sale and losing it. 1. Use Use the the Wor World ld Wide Wide Web Web to to res resea earc rch h how how bus busin ines esse sess on on the the Web Web con conduc ductt cre credi dittcard transactions. How do they secure the privacy privacy of these transactions? that offer credit card Answer: Student’s answers will vary. Most web hosting companies that transactions offer secure sites. sites. The key is to make sure sure that the transaction transaction is being processed through SSL (Secure Socket Layer).

B. E-Business And Credit Cards 1. When it comes to online business transactions, currently the most common way to

make a payment is via credit cards. 2. Debit cards - which authorize merchants to electronically debit your bank account - are also being used. 3. A number of electronic payment systems - sometimes referred to as "electronic money" - are under development dev elopment for simplifying purchases online. 4. Some new Internet-based payment systems would allow value to be transmitted through computers. a) Consumers can use them to make "micro-payments". "micro-payments". Micro-payments are extremely small payments - for an item like a sheet of music or a short article.

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b) When consumers use electronic money to make a purchase, they decrease the

balance on their card or computer by the amount of the purchase. c) Some cards can be "reloaded" with additional value, say, at a cash machine; other cards are "disposable" - you can throw them away after you use them. 5. Many potential consumers are hesitant about online transactions for reasons of security and privacy. a) In a recent study conducted by CyberDialogue, an online customer intelligence firm, 60 percent of online users still feel that submitting information is riskier than by telephone, and more than one-third feel that it is an invasion of privacy. b) Because of merchant and consumer vulnerability, credit card processing companies have developed a variety of ways to compensate for the exposure to risk. 6. E-commerce requires the business to integrate a variety of electronic services into a seamless shopping experience. a) While this is not currently a perfected process, nor is it one without inherent hassles for the merchant – the payoff of a small local entrepreneur being able to tap into a global market is often well worth the trouble. C. Installment Credit 1. Small companies that sell big-ticket consumer durables--major appliances, cars,

and boats--frequently rely on installment credit. 2. The time horizon may range from just a few months up to 30 or more years. a) Most companies require the customer to make an initial down payment. b) One advantage of installment loans for a small business is that the owner retains a security interest as collateral on the loan. c) If the customer defaults on the loan, the owner still holds the title to the merchandise. d) Because installment credit absorbs a small company's cash, many rely on financial institutions such as banks and credit unions to provide the installment credit. D. Trade Credit 1. Companies that sell small-ticket items frequently offer their customers trade 2. 3. 4. 5. 6.

credit; that is, they create customer charge accounts. accou nts. The typical small business bills its credit customers each month. To speed collections, some offer cash discounts. The small business owner must make sure that the firm's cash position is strong enough to support that additional pressure. For manufacturers and wholesalers, trade credit is traditional. Small businesses must be willing to grant credit to purchasers in order to get, and keep, their business; they must work extremely hard, and often be very tough, with debtors who do not pay as they agreed to.

Chapter Summary 1. Describe effective pricing techniques for both new and existing products and services.

Chapter 10 - Pricing P ricing and Credit Strategies 

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Pricing a new product is often difficult for the small business manager, but it should accomplish three objectives: getting the product accepted; maintaining market share as the competition grows; and earning a profit. There are three major pricing strategies generally used to introduce new products into the market: penetration, skimming, and sliding down the demand curve. Pricing techniques for existing products and services include odd pricing, price lining, leader pricing, geographic pricing, opportunistic pricing, discounts, multiple pricing, bundling, and suggested retail pricing.

2. Discuss the links among pricing, image, and competition. 

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Company pricing policies offer potential customers important information about the firm’s overall image. Accordingly, when developing a marketing approach to pricing, business owners must establish prices that are compatible with what their customers expect and are willing to pay. Too often, small business owners underprice their goods and services, believing that low prices are the only way they can achieve a competitive advantage. They fail to identify the extra value, convenience, service, and quality they give their customers—all things many customers are willing to pay for. An important part of setting appropriate prices is tracking competitors’ prices regularly; however, what the competition is charging is just one variable in the pricing mix. When setting prices, business owners should take into account their competitors’ prices, but they should not automatically match or beat them. Businesses that offer customers extra quality, value, service, or convenience can charge higher prices as long as customers recognize the “extras” they are getting. Two factors are vital to studying the effects of competition on the small firm’s pricing policies: the location of the competitors and the nature of the competing goods.

3. Explain the pricing techniques used by retailers. 

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Pricing for the retailer means pricing to move merchandise. Markup is the difference between the cost of a product or service and its selling price. Age of retail price, but some retailers put a Standard markup on all their merchandise; more frequently, they use a flexible markup.

4. Explain the pricing techniques used by manufacturers. 

A manufacturer’s pricing decision depends on the support of accurate cost accounting records. The most common technique is cost-plus pricing, in which the manufacturer charges a price that covers the cost of producing a product produ ct plus a reasonable profit. Every manufacturer should calculate a product’s breakeven price, the price that produces neither a profit nor a loss.

5. Explain the pricing techniques used by service firms. 

Service firms often suffer from the effects of vague, unfounded pricing procedures and frequently charge the going rate without any idea of their costs. A service firm must set a price based on the cost of materials used, labor involved, overhead, and a profit. The proper price reflects the total cost of providing a unit of service.

6. Describe the impact of credit on pricing.


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Offering consumer credit enhances a small company’s reputation and increases the probability, speed, and magnitude of customers’ cu stomers’ purchases. Small firms offer three types of consumer credit: credit cards, installment credit, and trade credit (charge accounts).

Discussion Questions 1. What does a price price represen representt to the customer customer?? Why is a custome customerr orientatio orientation n to pricing pricing important? service. Price is a measure of what a Answer - price is the monetary value of a good or service. customer is required to give give up to obtain a good or service. service. For an individual, price is a reflection of value. We, as individuals, pay no more more than what we believe the good or service to be worth. In the total marketplace, marketplace, all potential customers evaluate the available goods and services and establish the demand for each. Value, like beauty, is in in the eye of the beholder. The process of setting setting the price for any good or service service must involve an analysis analysis of how the market views the value v alue of that product or service. Entrepreneurs must develop a keen sensitivity to the psychological and economic thinking of their customers. Without being “in tune” to to the customer’s psychological and economic motivators and the resultant most likely buying behavior, it is possible to price the good or service incorrectly. This needed customer orientation orientation is an important non-quantitative factor factor in a successful pricing process. What the process achieves is seldom an “ideal” price, but a price range. This price range can be described described as the area between the price ceiling, ceiling, which is the most the target group would be willing to pay, and the the price floor. The price floor is established by the firm’s total cost to produce the product or provide the service.

2. How does does pricin pricing g affect affect a small small firm' firm'ss image? image? Answer - One of the toughest decisions small business owners face, but it is also one of the most important. Prices that are too high will hurt a company's sales. Pricing products or services too low, a common tendency tenden cy among start-up businesses, will rob a company of profits, threaten its long-term success, and leave customers with the impression that its products or services are of inferior quality. Improper pricing has destroyed cou ntless businesses. 3. What competiti competitive ve factors must must the small small firm conside considerr when establishin establishing g prices? Answer - Most entrepreneurs approach setting the price of a new product with a great deal of apprehension because they have no precedent. When pricing any new product, the owner should try to satisfy three objectives. 1) Get the product a ccepted. No matter how unusual a product is, its price must be acceptable to the firm's potential customers. 2) Maintain market share as competition grows. If a new product is successful, competitors will enter the market, and the small company must work to expand or at least maintain its market share. 3) Earn a profit. Obviously, a small firm must establish a price for the new p roduct that is higher than its cost. Managers should not introduce a new product at a price below cost because it is much easier to lower the price p rice than to increase it once the product is on the market. 4. Describe Describe the strategies strategies a small small business business could use use in setting setting the price of a new product. product. What objectives should the strategy seek to achieve? Answer - Entrepreneurs have three basic strategies to choose from in establishing a new product's price: penetration, skimming, and sliding down the demand curve.

Chapter 10 - Pricing P ricing and Credit Strategies 

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Penetration--introducing a product into a highly competitive market in which a large number of similar products are competing for acceptance, the product must penetrate the market to be successful. The objective is to gain quick acceptance and extensive distribution in the mass market; a company introduces the p roduct at a low price--just above total unit cost to develop a wedge in the market and quickly achieve a high volume of sales. Skimming--often is used when a company introduces a new product into a market with little or no competition. The objective is to quickly recover the initial developmental and promotional costs of the product. This pricing tactic o ften reinforces the unique, prestigious image of a store and projects a quality picture of the product. Sliding down the demand curve--a variation of the skimming pricing strategy is called sliding down the demand curve. The objective is to beat other businesses in a price decline; the small company discourages competitors and, over time, becomes a highvolume producer.

5. Define the the following following pricing pricing techniques: techniques: odd pricing, pricing, price price lining, lining, leader pricing, pricing, geographic geographic pricing, and discounts. Answer - Although studies of consumer reactions to prices are mixed and generally inconclusive, many small business managers use the technique known as odd pricing. They set prices that end in odd numbers (frequently 5,7,9) because they believe that an item selling for $12.95 appears to be much cheaper than an item selling for $13.00. Price lining is a technique that greatly simplifies the pricing function. The manager stocks merchandise in several different price ranges or price lines. Each category of merchandise contains items that are similar in appearance, quality, cost, performance, or other features. Leader pricing is a technique in which the small retailer marks down the customary price (i.e., the price consumers are accustomed to paying) of a popular item in an attempt to attract more customers. Geographic pricing. Small businesses whose pricing decisions are greatly affected by the costs of shipping merchandise to customers across a wide range of geographic regions frequently employ one of the geographic pricing techniques. a) Zone pricing--a small company sells its merchandise at different prices to customers located in different territories. b) Uniform delivered pricing--a technique in which the firm charges all of its customers the same price regardless of their location, even though the cost of selling or transporting merchandise varies. c) F.O.B. factory--the small company sells its merchandise to customers on the condition that they pay all shipping costs. Opportunistic Pricing. When products or services are in short supply, customers are willing to pay more for products they need. Many small businesses use discounts, or markdowns, reductions from normal list prices, to move stale, outdated, damaged, or slow-moving merchandise. Multiple pricing is a promotional technique that offers customers discounts if they purchase in qu antity. Bundling is the grouping together of several products or services, or both, into a package that offers customers extra value at a special price. 6. Why do many small small businesses businesses use use the manufactur manufacturer's er's suggested suggested retail retail price? price? What are the the disadvantages of this technique? Answer - Many manufacturers print suggested retail prices on their products or include them on invoices or in wholesale catalogs. Small business owners frequently follow these suggested retail prices because doing so eliminates the need to make a pricing decision.

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Following prices established by a distant manufacturer may create problems for the small firm such as it does not take into consideration the small firm's cost structure or competitive situation. 7. What is is a markup? markup? How is it used used to determine determine prices? prices? Answer - The basic premise of a successful business operation is selling a good or service for more than it costs to produce it. The difference between the cost of a product or service and its selling price is is called markup (or markon). Markup can be expressed in dollars or as a percentage of either cost or selling price: a) Dollar markup = Retail price - Cost of the merchandise b) Percentage (of retail price) markup = Dollar markup Retail price c) Percentage (of cost) markup = Dollar markup Cost of unit The cost of merchandise used in computing markup includes not only the wholesale price of the merchandise but also any incidental costs (e.g., selling or transportation charges) that the retailer incurs and a profit minus any discounts (quantity, cash) that the wholesaler offers. Once business owners have a financial plan in place, including sales estimates and anticipated expenses, they can compute the firm's initial markup. The initial markup is the average markup required on all merchandise to cover the cost of the items, all incidental ex penses, and a reasonable profit 8. What What is a standa standard rd marku markup? p? A flexi flexible ble marku markup? p? Answer - Some businesses use a standard markup on all of their merchandise. Usually used in retail stores carrying related products, it applies a standard percentage markup to all merchandise. Most stores find it much more practical to use a flexible markup, which assigns various markup percentages to different types of products. On ce owners determine the desired markup percentage, they can compute the appropriate retail price. 9. What is is follow-t follow-the-lea he-leader der pricing pricing?? Why is is it risky? risky? Answer - It is when small companies simply follow the prices that their competitors establish. Managers wisely monitor their competitors' pricing policies and individual prices by reviewing their advertisements or by hiring part-time or full-time comparison shoppers. It doesn't take into consideration cost differences and it is a "me-too" strategy eliminating some differentiation. 10. What is cost-plus pricing? pricing? Why do so many manufacturers use it? What are the disadvantages of using it? Answer - The most commonly used pricing technique for manufacturers is cost-plus pricing. Using this method, manufacturers establish a price composed of direct materials, direct labor, factory overhead, selling and administrative costs, plus the desired profit margin. The main advantage of the cost-plus pricing method is its simplicity. Given the proper cost accounting data. computing a product's produc t's final selling price is relatively easy. Also, because it adds a profit onto the top of the firm's costs, the manufacturer is guaranteed the desired profit margin. However, it does not encourage the manufacturer to to use its resources efficiently. And,


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because manufacturers' cost structures vary so greatly, cost-plus pricing fails to consider the competition sufficiently. 11. Explain the difference between full-absorption costing costing and direct costing. costing. How does absorption costing help a manufacturer determine a reasonable price? Answer - One requisite for a successful pricing policy in manufacturing is a reliable cost accounting system that can generate timely reports to determine the costs of processing raw materials into finished goods. The traditional method of product costing is called absorption costing because all manufacturing and overhead costs are absorbed into the finished product's total cost. Absorption costing includes direct materials and direct labor, plus a portion of fixed and variable factory overhead costs, in each unit manufactured. A more useful technique for managerial decision-making is variable (or direct) costing, in which the cost of the products manufactured includes only those costs that vary directly with the quantity produced. A manufacturer's goal in establishing prices is to discover the cost combination of selling price and sales volume that exceeds the variable costs of producing a product and contributes enough to cover fixed costs and earn a profit. Full-absorption costing is that it clouds the true relationships among price, volume, and costs by including fixed expenses expen ses in unit cost. Direct-costing basis yields a constant unit cost of the product no matter what the volume of production is. 12. Explain the techniques for a small small service firm setting setting an hourly price. Answer - Service businesses must establish their prices on the basis of the materials used to provide the service, the labor employed, an allowance for overhead, and a profit. Most service firms base their prices on an hourly rate, usually the actual number of hours required to perform the service. Some companies, however, base their fees on a standard number of hours, determined by the average number of hours needed to perform the service. For most firms, labor and materials constitute the largest portion of the cost of the service. To establish a reasonable, profitable price for service, the small business owner must know the cost of materials, direct labor, and overhead for each unit of service. Using these basic cost data and a desired profit margin, the owner of the small service firm can determine the appropriate price for the service. Smart service shop owners compute the cost per production hour at regular intervals throughout the year because they know that rising costs can eat into their profit margins very quickly. 13. What is the relevant price range for a product or service? Answer - Setting prices with a customer orientation is more important than trying to choose the ideal price for a product. For most products, there is an acceptable price range, not a single ideal price. This price range is the area between the price ceiling defined by customers and the price floor established by the firm's cost structure. Identifying the price ceiling requires entrepreneurs to understand their customers' characteristics and buying behavior. The price floor depends on a company's cost structure, which can vary considerably from one business to another. The entrepreneur's goal should be to position the firm's prices within this acceptable price range. The final price that business owners set depends on the desired image they want to create for their products or services: discount (bargain), middle-of-the-road (value), or prestige (upscale). Business owners must walk a fine line when pricing their products and services, setting their prices high enough to cover costs and earn a reasonable

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profit but low enough to attract customers and generate an adequate sales volume. Furthermore, the right price today may be completely inappropriate tomorrow because of changing market and competitive conditions. 14. What advantages and disadvantages does offering trade trade credit provide to a small business? Answer – Companies that sell small-ticket items frequently offer their customers trade credit; that is, they create customer charge accounts. The typical small business bills its credit customers each month. The small business owner must make sure that the firm's cash position is strong enough to support that additional pressure. For manufacturers and wholesalers, trade credit is traditional. Small businesses must be willing to grant credit to purchasers in order to get, and keep, their business; they must work extremely hard, and often be very tough, with debtors who do not pay as they agreed to. 15. What are the most commonly used methods to purchase online using credit? What reasons can you give for consumer uncertainty when giving credit card information online as opposed to via the telephone? Answer – When it comes to online business transactions, currently the most common way to make a payment is via credit cards. Debit cards that authorize merchants to electronically debit your bank account are also being used. Debit card may be automated teller machine (ATM) card and may require using a personal identification number (PIN). It may be a card that requires only some form of signature or other identification; or it may ha ve a combination of these features. While using a debit card is similar to using a credit card, there is one important difference: when using a debit card, the money for the purchase is transferred almost immediately from your bank account to the merchant's account. The Internet is a dynamic environment and forms of payment are rapidly evolving. So it's no wonder that a number of o f electronic payment systems - sometimes referred to as "electronic money" - are under development for simplifying purchases online. Some new Internet-based payment systems would allow value to be transmitted through computers. Consumers can use them to make "micro-payments". Micro-payments are extremely extremely small payments - for an item like a sheet of music or a short article. When consumers use electronic money to make a purchase, they decrease the balance on their card or computer by the amount of the purchase. Some cards can be "reloaded" with additional value, say, at a cash machine; other cards are "disposable" - you can throw them away after you use them. Internet vendors are constantly challenged by the need to provide secure ways to transact business in a safe environment. environment. Many potential consumers are hesitant hesitant about online transactions for reasons of security and privacy. Because of merchant and consumer vulnerability, credit card processing companies have developed a variety of ways to compensate for the the exposure to to risk. E-commerce requires the business to integrate a variety of electronic services into a seamless shopping experience. While this is not currently a perfected process, nor is it one without inherent hassles for the merchant – the payoff p ayoff of a small local entrepreneur being able to tap into a global market is often well worth the trouble. 16. What advantages does accepting credit cards provide a small business? What costs are involved? Answer – In today’s business environment, it has become essential to link the firm’s pricing strategy with its its credit strategy. In excess of 8 million million American households have credit


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cards and the estimate of the number of credit cards per person is between 4 and 5. Individuals on the eastern seaboard have more more credit cards and the highest credit credit limits. In contrast, the most conservative credit credit card users were located in in the Midwest. Interest payments on credit card balances have now become a significant part of our monthly budget. American consumers have racked up $462 billion in bank and credit card debt and an additional $88 billion in retail retail credit card debt. More small businesses also are equipping their stores to handle debit-card transactions, which act as electronic checks, automatically deducting the purchase amount from a customer’s checking account. The equipment is easy to install and to set up, and the cost to the company is negligible. The payoff can be big, however, in the form of increased increased sales. Although it has become an essential essential element of business, credit card sales have many associated fees. Not all merchant account providers charge all of these fees, but b ut expect to see some of these: a) application fee (usually waived), b) equipment fee, c) licensing fee, d) transaction fee, e) holdbacks and chargebacks. 17. What steps should a small small business owner take to earn earn merchant status? tips include: Answer - See "Gaining a Competitive Edge,". A few tips Recognize that business start-ups and companies that have been in business less than three years face the greatest obstacles in gaining merchant status. Apply with your own bank first. Know what information the bank or ISO is looking for and be prepared to provide it. Make sure you understand the costs involved. Shop around. Have a knowledgeable attorney to look over your contract before you sign it. •

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Step into the Real World

1. Interview two successful small small retailers in your area and ask ask the following following questions: Do you seek a specific image through your prices? What role do your competitors play in pricing? Do you use specific pricing techniques such as odd pricing, price lining, leader pricing, or geographic pricing? How are discounts calculated? What markup percentage does the firm use? What is your cost structure? 2. Select an industry that has several competing small firms firms in your your area. Contact these firms and compare their approaches to determining prices. Do prices on identical or o r similar items differ? Why? 3. Contact two local small businesses: one that does accept credit cards and one that doesn’t. Ask the owner of the business that does accept credit cards why he or she does. What role do customers’ expectations play? Does the owner believe that accepting credit cards leads to increased sales? What does it cost the owner to accept credit cards? How difficult was it to gain merchant status? Does the business sell products to consumers or other businesses online? If so, what method of payment is used and how satisfied satisfied is the owner with with this method? Ask the owner of the business that does not accept credit cards why he or she does not. Has the business lost sales because it does not accept credit cards? What would wo uld it take and how much would it cost for the owner to be able to accept credit cards?

Chapter 10 Entrepreneurship by Zubair A Khan.

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